How to Find Financial Stocks With Little Liquidity Risk

Editor's note: This column was submitted by Stockpickr member Arnab Dasgupta.

The broad dislocation of credit and capital markets has resulted in a correction in every group of financial stocks -- banks, specialty finance companies as well as a club of investment vehicles called business development companies.

BDCs invest in middle-market private companies using strategies that generate a steady source of cash flow that is returned to investors in the form of dividends . These vehicles grow more attractive in market environments where liquidity is a concern thanks to the stocks' double-digit dividend yields.

However, the underlying reason for holding these investments in your portfolio is that they have a conservative capital structure relative to peers in the financials space.

As per the Registered Investment Advisor Act of 1940, BDCs are not allowed to carry more than 1:1 leverage. Several financial stocks now face liquidity risk because their collateral is subject to constant repricing leading to margin calls by investment banks. BDCs have secured lines of credit, all of which are non-recourse.

Fundamentally, in this environment they can take advantage of widening credit spreads and invest in higher-yielding assets possessing better risk-adjusted returns, thus improving operating return on equity (ROE) and dividend growth.

Due to the onset of an economic slowdown, credit risk continues to be a potential issue in such companies, and therefore I recommend only those that are invested higher up in the capital structure. For example, the portfolio breakdown should reflect a higher proportion of senior debt compared to subordinated debt.

Also, the names I discuss have above average debt/equity ratios that give them room to raise debt. We can all agree that it is almost impossible to raise equity in a non-dilutive manner in such market conditions.